1st Session - Chapter 1 - Overview of Financial Management and the Financial Environment

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Overview of Financial Management and the

Financial Environment

Main Source:BE Chapter 1

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Company’s Objective

Maximization of shareholders’ wealth,

Maximization company’s value by maximization free cash flows and

minimization cost of capital. See Figure 1.1. (BE) Watch carefully: Market price of

company’s stock.

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Determinants of Free Cash Flows

Sales revenues Operating costs (raw materials, labor,

etc.) and taxes Required investments in operations

(buildings, machines, inventory, etc.)

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What is the weighted average cost of capital (WACC)?

The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors)

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What factors affect the weighted average cost of capital?

Capital structure (the firm’s relative amounts of debt and equity)

Interest rates Risk of the firm Stock market investors’ overall

attitude toward risk

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What determines a firm’s value?

A firm’s value is the sum of all the future expected free cash flows when converted into today’s dollars:

)WACC1(

FCF....

)WACC1(

FCF

)WACC1(

FCFValue

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The Markets

Two groups: Real (tangible) markets for physical

assets Financial markets for financial

instruments Money markets Capital markets

See table 1-1 for major financial instruments

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Financial institutions

Capital formation process(See fig 1-2 (BE) for the diagram of capital formation

process) Direct transfers Indirect transfers, through

investment bankers financial intermediaries

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What are financial assets?

A financial asset is a contract that entitles the owner to some type of payoff. Debt Equity Derivatives

In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.

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Who are the providers (savers) and users (borrowers) of capital?

Households: Net savers Non-financial corporations: Net

users (borrowers) Governments: Net borrowers Financial corporations: Slightly

net borrowers, but almost breakeven

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Direct transfer (e.g., corporation issues commercial paper to insurance company)

Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement)

Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)

What are three ways that capital is transferred between savers and borrowers?

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Commercial banks Savings & Loans, mutual savings

banks, and credit unions Life insurance companies Mutual funds Pension funds

What are some financial intermediaries?

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The Top 5 Banking Companiesin the World, 12/2001

Bank Name Country

Citigroup U.S.

Deutsche Bank AG Germany

Credit Suisse Switzerland

BNP Paribas France

Bank of America U.S.

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What are some types of markets?

A market is a method of exchanging one asset (usually cash) for another asset.

Physical assets vs. financial assets Spot versus future markets Money versus capital markets Primary versus secondary markets

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How are secondary markets organized? By “location”

Physical location exchanges Computer/telephone networks

By the way that orders from buyers and sellers are matched Open outcry auction Dealers (i.e., market makers) Electronic communications networks

(ECNs)

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Physical Location vs. Computer/telephone Networks

Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange

Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets

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The Cost of Money

Interest rate (the “price of money”) is an interaction point between money supply and money demand.

Determinants: Production opportunities Time preferences for consumption Risk Inflation

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What do we call the price, or cost, of debt capital?

The interest rate

What do we call the price, or cost, of equity capital?

Required Dividend Capital return yield gain= + .

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Real versus Nominal Rates

r* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%.

= Any nominal rate.

= Rate on Treasury securities.

r

rRF

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r = r* + IP + DRP + LP + MRP.

Here: r = Required rate of return on

a debt security. r* = Real risk-free rate. IP = Inflation premium.DRP = Default risk premium. LP = Liquidity premium.MRP = Maturity risk premium.

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Premiums Added to r* for Different Types of Debt

ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

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Financial Management

How to run firm financially to achieve the objective, under a certain condition of financial environment.

Main elements of financial environment: Financial markets Financial institutions Financial regulations